China Feels Global Market Pain

The worldwide network of getting goods made and sold is becoming even more complex. But here’s how investors can benefit.

The global economy is loading up the moving vans again. Consider this example:

Foxconn International (OTC: FXCNY), the publicly traded subsidiary of Hon Hai Precision Industry (OTC: HNHPF), the world's largest electronics contract manufacturer, is moving its iPhone production to Zhengzhou, in China's Henan province. Foxconn is also moving its iPad production to Taiyuan, in Shanxi province, and its PC production to Wuhan, in Hubei province.

The company's existing production base in Shenzhen will be used for research and development.

Certainly a rash of recent suicides at Foxconn's Shenzhen factory added to the urgency. But these moves are all part of a long-term strategy at Foxconn—and at other manufacturing companies in industries from high technology to textiles—to move production from the coastal cities of southern China to the less-developed areas of central and northern China.

The purpose: to cut labor costs.

The Foxconn move is just the tip of a global iceberg. Chinese companies are moving inland to cut costs because their customers are looking to cut their costs by eliminating inefficient, high-cost suppliers and squeezing suppliers on prices. When possible, production will be moved from higher-cost countries such as China to lower-cost labor markets such as Vietnam or Bangladesh.

What we're seeing is a huge restructuring in the global supply chain aimed at reducing costs —again. The predictable result will be—again—the elimination of high-cost, low-value-added producers.

The underappreciated result—and here's the opportunity for investors—will be a vast increase in the complexity of an already terribly complex global supply chain. The beneficiaries of that increase will be a handful of companies that are positioned to execute the new complexities of sourcing, coordination, logistics, and transportation that this iteration of the global supply chain presents.

In this column, I'm going to outline some of the dimensions of this next generation in the global supply chain, then give you the names of three companies that are in position to take advantage of this development.

Cutting Costs Is Job Number One

The reason for all the change is simple: cost. In China, there's actually a worker shortage in the coastal areas that have long formed the basis of that country's world factory. And that's led to a bidding war for workers that has forced huge increases in the wages that manufacturers have to pay. On March 18, for example, coastal Guangdong, China's biggest exporting province, announced a 20% increase in the provincial minimum wage. That increase brought wages in Guangdong to parity with those in provincial rival Jiangsu, which had raised its minimum wage by 13% the previous month. The increase brought the average monthly pay—after adding in bonuses based on output—to a little less than $300 at current exchange rates.

Chinese manufacturers don't really have much choice but to try to cut costs somehow. They can't eat the extra wages themselves; many Chinese companies are barely profitable, with margins of 3% or less. And they can't pass the costs on to their customers because those customers have grown accustomed to annual price decreases over the past decade. (Remember that one of Alan Greenspan's explanations for why inflation was so low during the boom in the 1990s was that constant price decreases resulted from companies moving production to China's world factory.)

Those companies are taking steps of their own to make sure that prices to them keep on falling.

Article Continues on Page 2

|pagebreak|

For example, Wal-Mart Stores (NYSE: WMT) has launched a huge supply-chain overhaul designed to increase the percentage of goods it buys directly from manufacturers. Wal-Mart wants to cut out as many middlemen as it can. The company has said the effort will emphasize the $100 billion in sales (out of $400 billion) that Wal-Mart gets from its own private-label goods, which are manufactured by someone else to be sold under an in-house label such as Faded Glory. Right now, Wal-Mart buys only about 20% of those private-label goods directly from manufacturers.

The company estimates it can save $4 billion to $12 billion by shifting the way it buys its private-label goods.

Globalizing the Pain

The company also thinks it can find cost savings by even further globalizing the way it buys goods. Instead of its current practice of buying for each national market separately, Wal-Mart is creating four global merchandising centers. For example, a center in Mexico City will handle merchandising for emerging markets. The company plans to extend this strategy to global sourcing of fruits and vegetables, too.

As a result, companies in coastal China will find themselves in competition on price not just with companies in inland China, but also with companies in even-lower-cost economies around the world.

In textiles, for example, a company in coastal China, where wages range from $117 to $147 a month, will find itself in competition with companies in Bangladesh paying $60 a month. Of course, not everything is equal. The infrastructure to get goods from factory to buyer is better in coastal China than in inland China and better in inland China than in Bangladesh. Literacy is higher in China, too.

But you can see where the cost pressures are leading, right?

The drive to wring more costs out of the supply chain is a disaster for inefficient producers and even for reasonably efficient producers that can't find a way to compete with the rock-bottom wages in some developing economies. Remember how much fun the previous round of globalization was? Well, this is likely to be just as painful—only this time, the pain will be felt in Osaka and Guangdong.

Three Potential Winners

But there will be a few winners as well. Of course, that's true in specific industries where companies that can deliver on low costs will be able to pick up business. It's also true for those companies that will implement the new supply chain.

For example, Li & Fung (OTC: LFUGY), a Hong Kong company that handles sourcing in China for Wal-Mart, among other global companies, has expanded its own reach to include sourcing from Bangladesh and other low-cost economies. The company reported that in 2009, its business in Bangladesh grew 20%, while business in China declined by 5%.

Not every logistics company combines global sourcing with warehouses and other logistics services. But a company that does is in a position to pick up market share from this next level of complexity in the global supply chain.

I'd flag Expeditors International (Nasdaq: EXPD) as another winner in this restructuring of the supply chain. The company is in the business of designing cost-efficient ways to get goods from here to there and provides services such as vendor consolidation and distribution management that lie at the heart of any company's plans to actually wring savings out of its supply chain.

The third stock I'll add to this list is Lan Airlines (NYSE: LFL). The company has a big air-freight network linking South America and the United States through Miami. If you're going to buy from low-cost economies, you've got to have a way to get the goods to your customers.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.